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Tuesday, September 23, 2008

Obscene MERs

Preet over at Where Does All My Money Go recently discussed the importance of paying attention to investment fees. In a lighter moment, he had some fun with a fund screener and listed funds with yearly MERs above 8%! To appreciate how ridiculously high this is, you need to see the effect over a long period of time.

As I have discussed before, MERs are paid every year, and investors have to be cautious about comparing them to one-time costs. After one year in a fund charging an 8% MER you would still have 92% of your money. The next year, though, the fund would take 8% of your remaining 92% leaving you with 84.64% of your money.

Over 25 years, an 8% MER would chew up 87.5% of your money. Suppose that your initial investment grows to $250,000 after 25 years. If you didn’t have to pay the 8% MER, you would have finished with $2 million!

Things get even sillier with the worst fund Preet listed: “Dynamic Power Hedge Fund-F” with an MER of 13.94%. I’m not sure what this name means, but it does a better job of distracting us from its high fees than something like “Stodgy Limp Noodle Fund-Z.” After 25 years in this fund, 97.6% of your money is gone. If the fund’s managers were to re-invest the MER they collect from you back into the fund for 25 years, for every dollar of your money left in the fund, the fund’s managers would have over $40.

Don’t let these high MERs desensitize you, though. Anything over 2% looks outrageous to me. Even a 1% MER takes away 22% of your money after 25 years.

I would like to see funds have to report their MER25, which is 25 years worth of expenses rather than just the one-year MER. When comparing a 2% MER actively-managed mutual fund to a 0.2% MER index fund, both percentages seem trivially low. But their MER25s are 40% and 4.9%. This gives a better picture of the damaging effect of fees.

Preet: On the subject of prospectuses, I recall that when I first started out investing in mutual funds, I never had my attention drawn to a prospectus. I know that I must have been given one for each fund, because that's the law, but my advisor somehow managed to downplay it. It could have had dire warnings in red 36-point font and I might not have noticed because I never opened it. My guess is that the typical person doesn't even know what a prospectus is.

Good point - maybe having the MER listed beside the fund name on the statement, and the cost over 1 year and projected costs over 25 years would be better (and placed near the total account balance for those who do not look at the individual holdings on their statements).

BTW - did you change your feed details? The feed items are linking to the comments, not the posts...

You say: "Over 25 years, an 8% MER would chew up 87.5% of your money. Suppose that your initial investment grows to $250,000 after 25 years. If you didn’t have to pay the 8% MER, you would have finished with $2 million! Your math is off a bit. It all depends on the performance of the fund. For example, if the fund could return, say an impressive 20% before fees, then a $14,706 initial investment would become $250,000 in 25 years after fees, and 1.4 million without the fees.

I'm not trying to take away from your point. I'm always harping at friends and family about larger than necessary MERs.

Lance: I'm glad to see that at least one person was interested enough to check the math. I'm afraid, though, that you have a misunderstanding about how MERs are collected. If a fund has a gross 20% return and an 8% MER, that does not mean that the investors get a 12% return. The fund manager takes 8% of everything including gains. The investors would be left with 1.20x0.92=1.104, which means a 10.4% return. With this return, $14,706 would grow to $174,470 after 25 years.

In reality, MERs get collected continuously throughout the year, but their effect is as I have calculated.

The are more issues with obscene MER's. First brokerage commissions are not part of the MER . Further, the returns published assume all distributions are reinvested and additionally that they are tax-free.If front end loads were paid this would also add to the reduction of performance.

The are more issues with obscene MER's.Deferred sales charges for one if you try to escape the high MER's before 7 years are up.There's also the question of fund mergers-often the resulting MER can be higher than before the merger. Regulators are trying to fix the MER disclosure problem but industry is fighting back hard.See also OSC Staff Notice 81-709 for a host of investment fund disclosure issues including misleading advertising.

Kenkiv: Thanks for the pointer to the staff notice. I haven't read it yet, but plan to. I'm not surprised to hear that the industry is fighting disclosure rules. I find it hard to understand why an informed investor would pay such outrageous fees.

A note on MER calculation. First www.investored.ca has an excellent MER calculator.

Some math :IF A1 =assets at beginning of year then 1.20A1 = assets at end of year for 20% return.Assuming linear growth then impact of MER is 0.08 ( 1.2A1/2)=.096A1 so return = 1.20A1-0.09A1= 11.1 % return excluding FEL, brokerage commissions & taxes . MER is charged monthly to the fund on average assets, not all at year end. kenkivwww.canadianfundwatch.com416 244 5803